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Small Business Owners Can Now Deduct State Income Taxes as a Business Deduction

We have identified a new tax savings opportunity for small business owners having “pass through income” (PTE). Partners in partnerships and shareholders in S corporations can now deduct the state income taxes imposed on business income as a business deduction (instead of as an itemized deduction).

The Tax Cuts and Jobs Act of 2017 limited the itemized deduction for state taxes to $10,000. Lawmakers in several states, including Minnesota, have found a complicated way to circumvent this limitation. The IRS has confirmed in a recent pro-taxpayer ruling from the IRS (Notice 2020-75) that state income taxes paid by a PTE (S corporation or partnership) on its shareholders’ (or partners’) income are deductible on the PTE’s income tax return as a business deduction.

Minnesota has a new law that allows a PTE to elect to pay its shareholders’ (or partners’) state income taxes. The new MN PTE election, together with IRS notice 2020-75, provides a nice way for MN small business owners to circumvent the $10,000 limitation on the itemized deduction for state and local taxes. The state income taxes are deductible as business expenses on the PTE’s tax return, reducing the shareholders’ (or partners’) business taxable income. Several other states have enacted similar laws.

This is all very complicated. A good article with more details is attached.

Not only is this a permanent tax reduction, but it is also a classic tax-deferral opportunity for taxpayers looking to reduce their 2021 federal income taxes. Small business owners operating S corporations and/or partnerships should consult with their tax advisors before the end of December 2021 to discuss the benefits of paying their entity level PTE tax before year end. Paying the state income taxes by the end of 2021 allows a deduction for 2021. If paid in 2022 they should be deductible in 2022.

- Mark Gleason CPA

Minnesota’s pass-through entity tax credit
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